7702 Plan: Always a Bad Idea or Simply Misunderstood?

Several years ago (the details as to exactly when are a little hazy), someone somewhere within the insurance industry made a fascinating discovery, which gave way to something referred to as a 7702 plan.

What might this fascinating discovery be? A tax loophole? The introduction to a new financial product that would bring salvation to us all?

No…not even close. Instead, this very creative individual made a half-correct observation about how things get named after Internal Revenue Code (IRC) and decided to make their very own special financial savings vehicle: the 7702 plan. So, what is it?

Not All That Exciting

Allow me to deflate the big balloon of anticipation. It’s simply a life insurance contract. In truth, there is no such thing as a 7702 plan. But, to be fair, there’s also technically no such thing as a 401k plan.

The name is a colloquialism in reference to the IRC that establishes the particulars of the plan.

IRC 7702 speaks to the taxable implications of life insurance contracts (tricky, tricky). You see, some people feel the need to further inflate the importance of an idea.

Basically, using life insurance to intentionally create cash value is being called “the 7702 Plan” because it sounds so much cooler and more exclusive, prompting some people (you know who you are) to jump on board.

So…is it Legal?

Here’s the issue; IRAs and 401ks, which also are not themselves legally defined “plans,” both require the establishment of an account (a custody or trust account) to manage the funds as far as actual legislation is concerned.

That account is what gives the products their tax benefits.

With life insurance, the product itself contains the benefits. There is no special “account” per se.

There’s likely nothing flat-out illegal about referring to the ownership of life insurance to make use of its cash value features as a 7702 plan. However, based on the limited amount of personal finance knowledge most people have (and that includes agents/brokers, registered reps, and IARs very much included), this is one area where mischievousness has a lot of leverage and advantage.

Of course, the pendulum can swing both ways.

Just because an account is a 401k, IRA, etc. doesn’t necessarily make it a good idea. All you are essentially doing there is establishing a custody or trust account and paying the custodian or trustee fees to hold onto your assets. The account has tax favorable benefits so long as it complies with the appropriate IRC.

Now, there is a difference as regards the official establishment of that account.

The custody or trust account is required for the other accounts that are sometimes referred to as “qualified” (though this is a bit of a misnomer as a lot of people refer to IRAs as qualified, which is incorrect since qualified is a reference to the Employee Retirement Income Security Act–ERISA).

Not Illegal, but not Exactly Legitimate

7702 plans are basically a marketing angle, but then again, isn’t everything else these days?

The problem is more in the way agents present the plan. There are a collection of agents (and insurance companies) that have embraced the idea of talking people into liquidating their IRAs in order to fund their “7702 plans.”

While I won’t categorically declare this wrong, there’s not much evidence to suggest that it’s right.

It’s fine to point out that cash value life insurance has certain tax favorable benefits under IRC 7702 and that those benefits are hugely beneficial, especially for those whose incomes place them far beyond Roth IRA eligibility (yes, the back-door IRA method works, but $5,000 a year for someone who earns over $100,000 a year sort of makes all IRAs somewhat useless).

But, when someone starts pitching the sale of life insurance as the establishment of a 7702 Private Plan, a line has certainly been crossed.

The benefits exist, and they are huge, but this sort of marketing gimmick is what gets us in trouble and makes everyone’s lives more difficult.

A Little Finger Wag at the Industry

Again, we’re not exactly sure who to blame for the origination of this idea, but we’ve seen many of examples of agents and companies embracing it (I once received an illustration to review for a guy from Northwestern Mutual that had “7702 Plan” displayed on the cover page).

For a while, a lot of agents were hawking Indexed Universal Life as the 7702 Plan (after all, it had something to do with the stock market). We wonder why FINRA and the SEC want to regulate these products.

The idea of marketing insurance in this way was someone’s really creative but really bad idea.

There have been a lot of creative marketing pitches out of the insurance industry – from magically vanishing premiums to whole life as a 401k plan to 7702 plans.

But, if someone approaches you and starts to “recommend” that you move to a 7702 plan, best to shake your head and chastise them for their ridiculousness. Then, shoot us an email.

Brandon launched the Insurance Pro Blog in July of 2011 as a project to de-mystify the life insurance industry. Brandon was born in Northern New England, and he currently calls VT home. He attended Syracuse University and graduated with a triple major in Economics, Public Administration, and Political Science.